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Market Update -- In the Markets

Written by Derrick Wulf, CFA, Portfolio Manager

July 15, 2010

Here's a brief summary of what transpired in the economy and the financial markets during the past three months. We hope you'll find it a handy reference.

Monetary Policy
The Federal Reserve left monetary policy largely unchanged in the second quarter after completing its large-scale asset purchase program at the end of March, but there was much debate within the Fed about its holdings of mortgage-backed securities, its eventual exit strategy, the potential economic impact of the European sovereign debt crisis, and the appropriate policy response should economic and financial conditions deteriorate further. The committee convened two official meetings during the period, voting both times to hold the Fed's benchmark overnight lending rate in a range of 0 to ¼ percent. In the statement released after the most recent FOMC meeting held on June 23, committee members stated once again that they "anticipate that economic conditions… are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

Although some FOMC members had become concerned about the size of the Fed's balance sheet as the economy showed continued signs of recovery this spring, disappointing economic data in more recent months quickly quieted the "exit strategy" rhetoric. As job growth has come in below expectations and consumer confidence has fallen, several key Fed policymakers have come to believe that risks are now once again skewed towards further weakness. Moreover, low inflation readings, excess productive capacity, sluggish job growth, and waning fiscal stimulus have some Fed officials now quietly worry about deflation. As such, further quantitative easing initiatives have once again entered the public discourse as a possible course of action under a worst case scenario. While Fed officials still believe that risks of a "double dip" recession are remote, they are currently in no rush to tighten policy, and are widely expected to hold rates steady through the end of the year.

Treasuries
Treasuries rallied sharply in the second quarter as the European sovereign debt crisis led to a weakening of financial conditions and a reduction of global economic growth forecasts. Stubbornly high unemployment, low inflation, fiscal austerity measures, and accommodative monetary policy increased the appeal of Treasuries to an increasingly risk-averse investment community, leading to declines in Treasury yields and a flattening of the yield curve. Two-year yields fell 42 basis points, making a new all-time low before ending the quarter at 0.605%, while Five and Ten-year yields fell by 77 and 90 basis points, respectively. The outperformance of the long end helped compress the spread between 2 and 10 year notes by almost half a percentage point to end the period at 233 basis points, a level not seen since October 2009. The strong rally in Treasuries led to a hefty 4.69% return for the Barclays Capital U.S. Treasuries Index, it’s best quarterly performance since the fourth quarter of 2008.

Notably soft inflation data, which helped fuel the rally in nominal Treasury securities, caused TIPS to lag the performance of their non-indexed counterparts during the second quarter, with implied inflation breakevens moving sharply lower during the period. The yield spread between 5-year nominal treasuries and 5-year TIPS ended the quarter at 1.51%, down almost 28 basis points from its first quarter close, while 10-year breakevens fell more than 40 basis points to 1.84% at the end of June. Low resource utilization should keep inflation low in the near term, but steady demand growth should prevent the current disinflationary trend from turning into outright deflation. Meanwhile, large US fiscal deficits and a large increase in the monetary base could create larger structural inflation risks in the longer term if left unchecked.

Bond Markets
Bond markets registered solid returns in the second quarter, led by Treasuries which benefitted from a global flight to quality sparked by European sovereign debt weakness and renewed concerns about the pace and sustainability of the economic recovery. Corporate bonds lagged the strength in Treasuries as idiosyncratic risks compounded broader macro fears to push credit spreads wider. Financial reform legislation and the SEC's fraud charge against Goldman Sachs weighed on the financial sector while the gulf oil spill led to a sharp widening of spreads among associated energy and drilling companies. Overall the corporate bond market returned 3.42% for the quarter, according to the Barclays Capital Aggregate Index, underperforming duration-matched Treasuries by 225 basis points. The average option-adjusted spread of the corporate sector widened some 44 basis points to 193 basis points over Treasuries, its widest since December, 2009, after reaching a post-credit crisis low of 139 basis points in mid-April.

The mortgage market fared better, as lack of new supply helped dampen the impact of the Fed's exit from the buyer base. Though large scale buyouts of delinquent loans by Fannie Mae and Freddie Mac hurt some investors, the sector's relative safety from credit risks helped attract reinvestment dollars from cautious investors, leading to a modest richening of valuations. In fact, MBS was one of the few major sectors of the broad market that fared as well as Treasuries, posting a 2.87% return for the second quarter, essentially matching the performance of Treasuries on a duration-adjusted basis.

The ABS and CMBS sectors also posted positive returns but lagged Treasuries as credit spreads widened. Though supply technicals remained favorable, with maturities continuing to exceed new issue supply, investors marked down their assessment of credit fundamentals in response to a deterioration of financial conditions and a moderation in economic data, particularly employment. The ABS sector lagged duration-matched Treasuries by 8 basis points in the second quarter, while CMBS underperformed by 67 basis points. Spreads in the ABS and CMBS sectors widened an average of 16 and 45 basis points, respectively.

The spread widening seen in the investment grade corporate market was exaggerated in the high yield market, with the average option-adjusted spread of the Barclays Capital High Yield Index widening 130 basis points. Although the market materially underperformed Treasuries, the favorable interest rate backdrop and the sector's income advantage helped keep total returns in close to even for the period. Municipal bonds also experienced a widening of spreads as concerns about the fiscal health of many state and local governments continued to make headlines. That said, attractive valuations and pending tax hikes attracted new investors to the market, and helped the Barclays Capital Municipal Bonds Index produce a total return of just over 2%. International sovereign debt markets also underperformed U.S. Treasuries amid broad-based concerns about unsustainable fiscal deficits among some of the weaker debt-laden government bond issuers, particularly in Europe. Despite significant pledges of support by the ECB, investors remained cautious, causing most sovereign debt spreads to widen and leading to a decline of 2.43% in the Barclays Capital Global Aggregate Ex-USD Index on an unhedged basis.

Some additional data about the U.S. bond markets are shown in the charts below.